There were some great responses to my post last week as to the poor returns experienced by venture capital fund investors.

Some suggested that the blame for this lied more with the very difficult market and deal conditions of the past decade than with the VC investment model itself.

Typical was this comment submitted by a San Diego VC: "I agree that the VC fund industry is guilty as charged when it comes to being opaque as to real returns data, but I challenge you to revisit your analysis in 24 to 36 months, when we all will have had time to benefit from today’s strong M&A and IPO markets."

One reader reference Gust Founder David Rose’s new book - “Angel Investing: The Gust Guide to Making Money and Having Fun Investing in Startups” and to Rose’s main contention that to access the 25% IRR potential of the asset class one must hold positions in not less than 20 companies.

He asked, “Is this practical advice? I mean - who really has the time to find, diligence, and invest in dozens of companies? And for those that don’t, are there really any “Warren Buffet-types” to back in this asset class?”

This is the billion dollar question, is it not?

And while of course anyone will be very hard-pressed to even approach Warren Buffett’s other-worldly track record, there are some powerful forces right now driving the timeliness of venture investing via the “Berkshire Model.”

These forces fall into three main categories – Improved Liquidity, Investment Flexibility, and what let’s call “Labor Arbitrage.”

Improved Liquidity. Illiquidity is a huge elephant in the room when it comes to startup and emerging company investing. Most startups and early stage companies that seek outside investors are years away from investor liquidity – either via sale to a strategic or financial acquirer, or far more rarely via a Public Offering of the Company’s stock.

Now Berkshire Model companies, as entities with fundamentally investment vs. operating mindsets more naturally position, language, and network their businesses in finance contexts.

While doing so by no means assures successful outcomes, it does create the far more likely possibility of secondary market liquidity alternatives for investors that “want out” in the interim before the final exit.

Investment Flexibility. Investment companies in the Berkshire mold have great flexibility to structure investments of various types: traditional straight cash-for-equity, warrants, contingent warrants, revenue certificates, convertibles, in exchange for professional services, on project-by project bases, and more.

This flexibility is a game changer, as when done right it can provide managed, diversified exposure to a portfolio of deals and opportunities inaccessible via more “traditional” means.

Labor Arbitrage. A wise man once said that all businesses fundamentally do is “bridge the gap” between markets for labor and those for products and services.

Relatedly, one of the best advantages of the Berkshire model is the ability it affords to "Mark Up" the labor involved in effecting deals and transactions.

Let’s explain this by example.

Say a finance or advisory services professional is paid a salary of $80,000 per year, plus bonuses and incentives based on deals, transaction closings, and successful exits (not atypical terms).

Let’s then utilize a 20% load factor and assume that this worker’s fully loaded cost is $100,000 per year. Let’s then assume a 2,000 hour work year (we hope they work harder than this, as this is such an opportunity filled industry!).

Then, on a hourly basis, this professional’s fixed cost is approximately $50 per hour.

Now it is neither unusual nor unreasonable for even midlevel management consultants and investment bankers to bill out at $250 an hour and more on a cash basis, and much more than this on a cash equivalent basis when services are performed in exchange for contingent and / or equity compensation pay structures.

The critical point here is that when services are performed in exchange for equity compensation , even with average deal “picking” there is a natural Deal Arbitrage Effect that can easily create positive expected value on each and every deal.

A massive advantage.

Like everything associated with startup and emerging company investing, a lot of hard and smart work is needed to do it right.

All of a sudden, it is boom time again for venture capital funds, with over $10.3 billion in fresh capital raised by 578 funds in the 1st quarter, up 36% from 2012.

And high profile exits on deals like Nest, WhatsApp, and Occulus - where fund investors saw returns in excess of 20x their original investments - have caught the public's fancy as to the power of startup and emerging company investing.

So it should come as no surprise that a lot of folks want in on the action.

But for the individual investor, is investing in a venture capital fund really a good idea?

It can be, as the return examples above attest, but more and more it has become a losing game.

Here’s why:

Market Efficiency. With now over one thousand active U.S. venture funds - and with so many of them pursuing similar deal sourcing strategies and approaches - it has become extremely difficult for VCs to find and secure high potential, well priced deals.

The result has been a “regression to the mean” - with alpha performance by fund managers being driven as much by randomness and luck (as it has been with public market mutual funds for decades) as by coherent design.

Fees. The world of low and no load management fees that so transformed mutual fund investing for in the 80's and 90's is far from being on the VC radar.

In fact, as opposed going down, venture fund fees have been going in the other direction, with a number of higher profile funds upping their annual fees to 3% (along with asking for a greater share of the returns) versus the standard 2-2.5%.

These high fees obviously eat away at returns, and more profoundly are in contrast to the “disintermediation spirit” so at the heart of modern technology investing.

Friction. Little discussed in most venture fund models are the high costs of deal sourcing, diligence, and oversight.

It is not unusual for a venture fund to sort through thousands of possible investments, deeply diligence a few hundred, prepare and submit term sheets on a few dozen, and then do zero deals.

This all costs money.

And all this doesn’t even begin to measure the management and oversight costs on the deals that are done – which at their barest minimum range from quarterly board meeting attendance to monthly, weekly, and sometimes daily calls and meetings with portfolio companies.

All this work is necessary to do venture capital right, but is also expense and friction filled.

Now, funds do work to charge some of these costs back to their portfolio companies, but usually these offsets flow to the fund’s General and not its Limited Partners.

So what to do?

Well, for those that love the startup and emerging company asset class, but are reluctant to either a) put all of their eggs in one basket via investing in one particular startup directly and / or b) get the problems with the current VC model per the above, here are two ideas:

1. Explore Crowdfunding sites like Crowdfunder.com and peer-to-peer lending sites like Prosper.com and LendingClub, all of which offer various forms of fractionalized and securitized investing into the asset class.

2. Do Like Warren Does. The Berkshire Hathaway model of an “operating company owning other operating companies” can be a great gateway to the asset class, combining both diversification along with the the “pop” and fast liquidity potential that a single company investment allows. Well-run companies like this that focus on the startup space are hard to find, but when one does they are definitely worth a closer look.

In short, when it comes to asset class, the advice here is to avoid the VCs and explore investment models – some new and some old – that provide access to it in a lower cost, higher expected return, and all-around more investor-friendly way.

To Your Success,

P.S. Like to learn how to apply these principles to your portfolio? Then attend my webinar this Thursday, “What the Super Angels Know about Investing and What You Should Too.”

The saddest lament of entrepreneurs and owners of private companies seeking to sell and exit their companies is that they want their businesses to be valued on their future potential, and not its CURRENT profitability.

Given that the typical, offered purchase multiples for smaller businesses – as in those with less than $5 million in EBITDA – can be as low as 1 or 2 times last year’s tax return profits, this is understandable.

In fact, we often see purchase offers based on multiples of MONTHLY earnings – not exactly the “happily ever after” exit dreamed of when these businesses were founded!

Yes, getting a business valued and sold based on factors other than its earnings while by no means impossible nor uncommon, is HARD.

Yet…there are literally hundreds of companies every month that sell for very high multiples of profits, for multiples of revenue, and even companies that are in a pre-revenue stage that sell every day just on the value of their technology, their people, and their work processes.

What do they?

Well, here are six things that companies that sell for high multiples do that you can and should too.

1. They Are Technology Rich. Companies rich in proprietary technology in all its forms – patents, processes, and people – are far more likely to be valued on factors other than profitability and correspondingly attain purchase prices beyond a few times current year’s earnings.

As an example, the likelihood of a medical device company being sold or taken public is twenty times greater than that for a services - or a low-to-no proprietary technology company - doing so.

2.They Have Gold at the End of their Rainbows. Businesses that sell for high multiples communicate exciting and profitable future growth.

Their managers demonstrate understanding of the big 21st century “macros” - i.e. how technology evolutions and globalization will impact positively and negatively their industry, market, customers, and competition.

Concurrently, these managers understand the micros well too, especially how their business’ human capital will adapt and grow as change happens.

All this translates into well-developed stories that if their businesses aren’t making it now, there is gold (and a lot of it!) at the end of their rainbows.

3. They Are Great Places to Work. Businesses that sell are usually characterized by that good stuff that we all seek in our professional environments.

They are culturally cohesive. If they don’t have low employee turnover, they at least have well - defined career progression paths. And their compensation policies align and pay well with desired performance.

Quite simply, they are great places to work and are reputationally strong within their industries.

4. They are Process and NOT People Dependent. Businesses that are overly dependent on charismatic owners or a few dynamic salespeople or engineers rarely sell because the majority of their value can simply walk out the door tomorrow and never come back.

Important aside: for those entrepreneurs that harbor the desire to sell but not the ambition to build a meaningfully sized, process-based organization should then focus their exit planning almost exclusively on technology and intellectual property development.

If they are unwilling / unable to do this, then they should put the idea out of their head for now and invest this energy into more meaningful pursuits.

Like my favorite - making absolutely as much money today as one possibly can.

5. They Have Good Advisors. Businesses that do everything right but have messy financial statements because of poor accounting, messy corporate records because of poor or non-existent legal counsel, and messy “future stories” because of poor exit planning and investment banking advice, simply do not sell.

Sure, they may get offers, but invariably these deals fall apart in diligence and at closing.

And as anyone that has ever been through a substantial business sale process knows, almost nothing in business is as time and energy-draining as is getting close to a business sale and not getting it done.

6. They Get Lucky. Luck remains a fundamental and often dominant factor that separates the businesses that successfully sell from those that don’t.

The best entrepreneurs and executives don’t get philosophical nor discouraged by this but rather they embrace it.

They try new things. They follow hunches. They make connections.

They start from the pre-supposition of “accepting all offers” and work backward from there.

They and their companies can be best described as “happy warriors” – modern day action heroes ready for the fight. When they get knocked down, they smile, wipe their brow, and get right back in the fray.

And you know what? Our happy warriors, living and thinking and working like this day after day channel some mystical power and draw great luck and more to themselves and their companies.

Yes, companies that sell are the good and lucky ones.

Follow the advice above and fortune just may smile on your company and those you invest in too.

So now we are at brass tacks: actually making Yes/No decisions on specific deals and opportunities.

In other words, handicapping the probability of a company’s investment return projections actually coming to pass.

And relatedly, fair pricing and terms upon which to consummate a deal.

It is upon these “Due Diligence” matters where the real - as opposed to the theoretical - money on early stage deals is made.

Now, due diligence - as it is done by serious, professional investors - is an enormous undertaking.

It often requires hundreds and sometimes thousands of hours of accounting, legal and background reviews and checks, along with third party validation and research as to claims regarding market opportunity, competitive landscape and customer pipeline, traction, and satisfaction.

It can be as time, energy, and expertise intense as any business process or project one could possibly imagine.

And because it is so, for almost all individual investors doing it thoroughly and right is almost always completely unrealistic.

Luckily, there are some shortcuts that can yield similar investment insight.

I call them the “Who, Why, and When” 15 minute Modern Due Diligence Checklist.

Who. Easily the most important question to ask of any endeavor of importance: Who is involved? What are their personal and professional histories and backgrounds? Of leadership, business, investment and life success? Who are the professional partners (Law, Accounting, Banking, etc.)? Who is on the Board? (Is there a Board at all)? Who are the Customers? The Partners? The Employees?

When it comes to whether a deal is good or not, the answers to these “Who” questions is more often than not all you need to know.

Why. Why is a deal happening? Why are those who are involved in fact…involved? Why is the deal being offered to you?

Many were of the genre that “…Yes these companies you describe sound amazing - awesome technologies, exciting markets, management with knock-your-socks off resumes, but when it comes to actually investing them….”

…How do I even have a chance of separating the wheat from the chaff?

The superstars from the also-rans?

Or, more to the point, the ones that will make money from the ones that won't.

This is the ultimate question, isn’t it?

First of all, we are certainly not referring to “stock picking” to beat the markets. Everyone knows that this is not possible. (And if you have even a sliver of remaining doubt on this point, read this article).

And we're not talking about high profile, private companies that have already raised tens (and sometimes hundreds) of millions of dollars and are deep in the investment news cycle.

For these companies and hundreds of others backed by venture capital firms, by the time the public knows about them, almost always the best opportunity to invest in them has long past.

And, for the most part, we are also not talking about businesses or projects competing in mature and well-covered like Real Estate.

For sure, there are lots of solid real estate investment opportunities, but as it is such an efficient and well-covered market – with tens of thousands of investors seeking projects and deals of all sizes that the likelihood of finding those that offer returns even slightly above average is pretty low.

And let’s also cut out investing in “things” like art, collectibles, and commodities. While in places interesting for sure, statistics over a long period of time show that their average investment returns is significantly less than that of an S&P index fund.

So what investors seeking alpha are left with almost exclusively is that most special segment: startups and emerging companies.

Companies almost always with these characteristics:

They are Small. As in less then $10 million in in revenues and less than 30 employees. Not hard and fast rule, but holds true 95%+ of the tie.

They have an Ambitious Leader. At the beating heart of these companies is almost always a charismatic individual that leads big and manages small.

A leader with an articulate “point of view” on where a market and an industry are heading.

And who can then translate this vision to the day-to-day small business discipline required to turn dreams and visions into objective reality and results.

They Compete in Big Markets. This one is easier than ever before. Why?

Well, with a 7 billion person strong, $84 trillion global economy, almost every business – even those in the smallest of niches - has a large global opportunity.

Of course, to profit from them opportunities requires great leadership and management (see above) but the opportunities are everywhere.

Companies with Thoughtful Revenue Models. This is where the ability of a company's leader to think and act both “big” and “small” are so critical.

Quite simply, companies that build asset and equity value for their shareholders are vigilant in ensuring that their monetization strategies are built around long-term customer retention and satisfaction, and NOT short-term gain.

Companies that are Lucky. The new and eternal mantra of our age is luck. Books like the Black Swan, Fooled by Randomness, and the Age of the Unthinkable profess on it.

The good times continued in the 1990s. On January 1, 1990, the Dow Jones was at 2,810. By December 31, 1999, it had exploded to 11,497 -- an increase of 409% in just 10 years.

But today’s stock market is BROKEN.

From 2000 to TODAY, the Dow Jones has only moved from 11,078 to 16,700 (only 40%). And INFLATION has reduced purchasing power by 37%... which means the net returns of the Dow Jones have been close to ZERO.

Download this report and discover why the stock market is broken – and what you can do about it.

Last week my post on Silicon Valley - where I posed that the Valley as an investment hub had become overbought, and that the best opportunities were trending elsewhere - elicited some great responses.

Perhaps my favorite was from a Midwest VC, in reference to one of his portfolios companies in the data center space..."Here is an excellent company which is part of our VC portfolio that is…in the midst of the cold Midwest in Rochester, Minnesota, a location where few Silicon Valley folks are brave enough to consider for investment."

Another came from a well-known super angel from Dallas, “very much admire the wealth and innovation coming from SV, but it is time for investors to step out and see all of the great technology companies starting and growing outside of California.”

I appreciate these sentiments very much, and they got me thinking as to what are the common threads amongst those that love, work and invest in the startup and small business sector.

It starts with a set of beliefs. First and foremost, a clear and passionate recognition that the blessings of our way of life depend on our thriving free enterprise system.

And a deep and abiding respect for those that create wealth via their own hard work, creativity, and opportunistic sense of risk and reward.

For the entrepreneurs, the owner-operators, “the risk takers, the doers, the makers of things.”

Those brave souls that embody Picasso's famous credo of "work being the ultimate seduction.”

From whom business is far more than simply a way to make a living.

AND as they do it, they make money.

A lot of it.

In fact, the vast majority of startups and small companies earn a far higher return on invested capital than their larger publicly-traded brethren.

In fact, companies on the Inc. 5000 - a list of the country’s fastest-growing privately-held companies - average annual revenue growth of over 70%.

And a good number of these companies take in outside investment to accelerate their growth.

Some from professional investors - private equity and venture capital firms - and some from individual, “angel” investors.

And when the better among them do, those that love and are passionate about entrepreneurship, about technology, and about making money, want to participate.

Here’s why:

1. High Rate of Expected Return. Angel investing is by far the highest expected rate of return form of investing, Research from the Kauffman Foundation Angel Returns Study and the Nesta Angel Investing study, compiled by Robert Wiltbank, have demonstrated that the "...average angel investor (across the U.S. and UK) produced a gross multiple of 2.5 times their investment, in a mean time of about four years."

2. Home Run Potential. Smaller operating companies are the only form of investment that offer true "home run" potential.

Almost all great fortunes have been made via positions in small companies that became big. The list is legion, and runs from Standard Oil, DuPont, and Ford, through IBM, Hewlett-Packard, Wal-mart, Microsoft, and Oracle, to modern day supernovae like Amazon, Google, LinkedIN, Facebook, and Twitter.

And yes, Whats App and Occulus, too - companies still early in their business life but having already created fortunes for their early investors.

With 41% of all U.S. venture capital investing activity, Silicon Valley is the nation’s unrivaled tech early technology investing epicenter.

As the innovations and wealth that have flowed from Valley Tech companies - from Apple to Cisco to Ebay to Facebook to Google to HP to Netflix to Pixar to Oracle to Yahoo and thousands more - have enriched the world beyond measure.

And since the start of this year, almost impossible to believe stories of fortunes being made there have inspired us all (and provoked more than a little jealousy, too!).

I profiled a pair of these stories - Jim Goetz of Sequoia Capital parlaying a $58M investment into WhatsApp into a $3B fortune when in February Facebook purchased the messaging app

And Super Angels Peter Thiel and Sean Parker, who through their Founder’s Fund invested $16 million into virtual reality headset maker Occulus VR, which returned more than $740 million when Facebook bought the business last month.

Great for them.

But it does beg the question: Has Silicon Valley become so dominant - has it so separated itself - that the best opportunities can only be found there?

Of course not.

In fact, the argument can be made that the worst place to invest right now is in Silicon Valley.

As the stories above illustrate, deal prices there are high, and there is more money than ever (including $7 billion in fresh capital raised last quarter) chasing fewer and fewer deals.

So smart money is starting to look elsewhere.

Like in Los Angeles.

Long renowned as a digital media and entertainment hub, LA Tech investing activity has never been greater, with both funding and deal activity at a five year high.

Smart investors are making a lot of bets on young LA companies, with 70% of all area investing activity happening at the Seed and Series A stages.

Like in the Valley, Internet and Mobile-related businesses dominate - with close to 80% of all venture activity being concentrated in these areas.

Don’t you just love these booming markets? Well, if you don’t, try on these IPO, M&A, and financing stats from 1st Quarter 2014:

Initial Public Offerings: 72 companies went public in the U.S. in the 1st quarter - the largest number of new issuers since 2000 -raising a total of 11.1 billion. And, as of Monday 54 of the 72 of them were trading above their IPO price.

They also raised $10.3 billion for 578 funds in the 1st Quarter, up 51% from last year.

After many years of ongoing economic and investment dreariness, isn’t this so refreshing?

And aren’t we heartened that the doomsayers have been proven so fundamentally wrong?

Wrong about the U.S. economy.

And wrong about what is so clearly the dominant leadership position of this country in all of the great technologies growth industries of the 21st Century - software, biotechnology, energy, digital media, and more.

And beyond the numbers, there are some great stories.

Of new industries being built, of fortunes being made. Here is one of my favorites:

Global Technology Mergers & Acquisitions Activity is now at its highest year-to-date level since 2000 (in terms of both dollar volume and deal number).

Overall there has been $65.2 billion of M&A activity announced year-to-date (Thomson Reuters).

And then layer in the the crowdfunding boom (both donations and investment-based) and the exploding growth of peer-to-peer lending sites like Lending Club and Prosper.com, and never before have there been so many and so good “digital” places for those seeking and those providing capital to connect and transact.

The result?

More entrepreneurs and businesses having access to outside capital than ever before and...

…for the first time investors having the ability to efficiently build diversified portfolios of private equity and debt investments with strong, positive expected value.

Now compare all of this freshness and innovation against the ongoing dreariness of the “public” markets.

From 2000 to today, the Dow Jones has risen from 11,078 to approximately 16,268 (as of 03/26), or approximately 42%.

During that same time inflation has reduced the dollar’s purchasing power by almost exactly that same amount (38%).

So basically 15 years and ZERO real investment return.

Now what do these two fast diverging worlds, the increasingly innovative and transparent one of private investing on the one hand, and the flat and more opaque than ever one of the traditional public market returns on the other, mean for the entrepreneur and for the smaller investor?

And for the entrepreneur, it means more, quicker, and cheaper access to capital, especially in smaller amounts.

Which leaves more time and energy for what entrepreneurs want to do and what we all need them to do…

…starting and growing profitable and innovative companies that make the world a better place.

Amen to that.

To Your Success,

P.S. To listen to a replay of my Thursday webinar, where I explored some of the key lessons learned from Sequoia Capital's $58 million investment into WhatsApp - and subsequent $3 billion windfall - upon Facebook's purchase of the messaging app last month, click here.

A version of this article originally appearedin Entrepreneur Magazine and can be seen here.

Most entrepreneurs fail to raise
venture capital because they
make a really BIG mistake when
approaching investors. And on
the other hand, the entrepreneurs
who get funding all have one thing
in common. What makes the difference?